What’s the euro endgame?

I’ve been watching developments in euro-land, wondering how the crisis ends. I’ve become tangled in the notion of expectations and what they mean for the euro endgame.

Let’s take a two-country model with Greece and Germany. They are negotiating over how to divide up the losses on loans to Greece. Greece has to make good on some portion of the loans, and that money has to come from the government and ultimately the Greek economy. So, austerity for the Greeks, in the sense that future consumption must be reduced to pay for past borrowing. Germany wants to be repaid, at least in part. Germans have to decide, technocratically or politically, how much of the loans they will write off. They are essentially trying to figure out how much plucking the Greek goose can undergo before the hissing is too much.

Of course, Greece has the other option: exit from the euro. Yes, it will be painful and economically disruptive. Austerity will also be painful and politically disruptive.

Now it becomes a game of expectations. Greece will stay in the euro as long as the expected pain from German demands are less than the expected pain from exit. If current demands — the current amount of demanded austerity — are unsustainable, then Greece is expecting Germany to lower its demands. So now the situation is:

Greece expects Germany to lower its demands — Greece remains in the euro

Greece expects exit to be worse than austerity — Greece remains in the euro

Greece expects the current austerity and any future potential German concessions to be worse than exit — Greece exits the euro.

World opinion seems to be that the current plan is unsustainable, that Greece can’t ‘trade through’ as they say for businesses. So, that must mean that Greece is betting that future concessions will make the difference.

My problem is that there is a first-mover advantage. If you expect that in time t the deal will be unsustainable, then you should make your move in period t-1. But if that is true, then you are even better off making the move in period t-2. The thing that keeps you from making your move early is the expectation (hope?) that the deal will change, that things will get better.

But it also isn’t a binary situation. There is a range of possible actions or concessions that can improve Greece’s situation. Germany is trying to maximise the expected value of its claims on the Greek economy, so it is trying to figure out the minimum concessions necessary to keep Greece in the euro.

This logic leads to the conclusion that both countries have an interest in maintaining the crisis. As long as Germany looks like it might offer concessions, then Greece expects that future austerity won’t be as bad as the current plan. As long as Greece’s finger hovers over the ‘exit euro’ button, it has a credible threat and can extract more concessions. Current uncertainty is the price both countries are willing to pay to increase the expected long-term payoff.